The Causes, Solution and Consequences of the 1997 Monetary Crisis Situation of the Czech economy before the crisis Situation of the Czech economy before the crisis The 1997 monetary crisis – why did it happen? The 1997 monetary crisis – why did it happen? The crisis development The crisis development Consequences of the crisis Consequences of the crisis Different crisis explanations Different crisis explanations Presentation availability: in „Study materials“ at is.muni.cz Presentation availability: in „Study materials“ at is.muni.cz

Czech economy in the middle of the 90´s satisfactory stage of the economic reform satisfactory stage of the economic reform most basic reform steps were made most basic reform steps were made solid economic growth solid economic growth low unemployment rate low unemployment rate good future view of macro aggregates good future view of macro aggregates

Czech economy in the middle of the 90´s Source: Czech Statistical Office,

Czech economy in the middle of the 90´s Unemployment rate in the Czech Republic Source: Czech Statistical Office,

The 1997 crisis – why did it happen? several causes (factors) several causes (factors) all of them „worked“ together all of them „worked“ together direct relationship between the external imbalance and the Czech koruna exchange rate direct relationship between the external imbalance and the Czech koruna exchange rate 4 main causes: excessive domestic demand, exchange rate regime, short-term foreign capital influx, monetary policy 4 main causes: excessive domestic demand, exchange rate regime, short-term foreign capital influx, monetary policy

1. Overheating of the Czech economy → excessive domestic demand one of the fastest economic growths in Europe one of the fastest economic growths in Europe excessive domestic demand (theory of „transformation wage pillow“) excessive domestic demand (theory of „transformation wage pillow“) insufficient domestic supply insufficient domestic supply imports as a natural valve of this imbalance imports as a natural valve of this imbalance huge current account deficits huge current account deficits pressure on the CZK depreciation pressure on the CZK depreciation

Relationship between GDP growth (g) trade balance (NX) g NX NX

BP development Current Account Financial Account Change of Reserves Source: Czech Ministry of Finance Deepening CA Deficit

2. Exchange rate regime fixed exchange rate regime since the beginning of the transition process fixed exchange rate regime since the beginning of the transition process central parity at 28 CZK/1 USD with +- 0,5% fluctuation zone central parity at 28 CZK/1 USD with +- 0,5% fluctuation zone undervalued CZK as another „transformation pillow“ undervalued CZK as another „transformation pillow“ good anti-inflation instrument good anti-inflation instrument but: real exchange rate problem but: real exchange rate problem question of „crawling peg“ implementation question of „crawling peg“ implementation

Real CZK exchange rate R D/F = E D/F. P F /P D where: R D/F = E D/F. P F /P D where: R D/F …real exchange rate domestic/foreign currency R D/F …real exchange rate domestic/foreign currency E D/F …nominal exchange rate domestic/foreign currency E D/F …nominal exchange rate domestic/foreign currency P F …foreign price level, P D …domestic price level P F …foreign price level, P D …domestic price level if R > 1, domestic goods relatively cheaper → to acquire 1 foreign cage of goods you have to offer more than 1 domestic cage of goods if R > 1, domestic goods relatively cheaper → to acquire 1 foreign cage of goods you have to offer more than 1 domestic cage of goods if R < 1, foreign goods relatively cheaper → to acquire 1 foreign cage of goods you have to offer less than 1 domestic cage of goods if R < 1, foreign goods relatively cheaper → to acquire 1 foreign cage of goods you have to offer less than 1 domestic cage of goods

Real exchange rate CZK/DEM, 1991=100 Source: Vencovský, Komárek (1998) For example: if you got 1 German commodity cage for 500,- CZK in 1991, you could get the same German commodity cage for cca 250,- CZK in 1998 → that's how the real appreciation of CZK worked

Real CZK exchange rate Exchange rate trends – relation Czech Republic – Germany (1991=100) Source: Vencovský, Komárek (1998) Inflation differential

Relationship between real exchange rate (R) and trade balance (NX) NX R NX revaluation devaluation

3. Influx of short-term foreign capital problem of co-existence of fixed exchange rate regime and liberalized capital flows problem of co-existence of fixed exchange rate regime and liberalized capital flows minimal exchange rate risk for foreign capital minimal exchange rate risk for foreign capital positive interest-rate differential (Czech real interest rates higher than in other transition countries) positive interest-rate differential (Czech real interest rates higher than in other transition countries) increasing ratio of short-term capital on the financial account increasing ratio of short-term capital on the financial account virtually no problem with current account deficits – CA def. covered by FA surpluses virtually no problem with current account deficits – CA def. covered by FA surpluses but: dangerous structure of BP but: dangerous structure of BP

BP development Current Account Financial Account Change of Reserves Capital flows liberalization

4. Monetary policy of Czech National Bank restrictive monetary policy in the early 90´s – main goal – decrease inflation restrictive monetary policy in the early 90´s – main goal – decrease inflation since 1993 – slightly expansionistic – main goal – economic growth since 1993 – slightly expansionistic – main goal – economic growth 1995 – full liberalization of capital flows – since that – increase of short-term capital influx 1995 – full liberalization of capital flows – since that – increase of short-term capital influx February 1996 – widening of fluctuation zone of CZK to +-7,5% - the goal to raise the exchange rate risk February 1996 – widening of fluctuation zone of CZK to +-7,5% - the goal to raise the exchange rate risk bond-sales to eliminate the excessive growth of monetary base bond-sales to eliminate the excessive growth of monetary base crowding-out effect of bond-sales – another growth of interest rates, and another influx of short-term capital crowding-out effect of bond-sales – another growth of interest rates, and another influx of short-term capital in 1996 – the need of restriction – middle 1996 – CNB increased the minimal required reserves rate, and basic interest rates in 1996 – the need of restriction – middle 1996 – CNB increased the minimal required reserves rate, and basic interest rates

1996 monetary restriction as the brake of economic growth 1996 monetary restriction as the brake of economic growth slower economic growth – impulse for short-term foreign capital to „cast away“ slower economic growth – impulse for short-term foreign capital to „cast away“ Monetary policy of Czech National Bank Source: Centre for Economics and Politics (2000) Monetary Restriction

Development of the crisis wrong prediction of macroeconomic aggregates for 1997 wrong prediction of macroeconomic aggregates for 1997 April 1997 – state budget deficit (the new phenomenon) April 1997 – state budget deficit (the new phenomenon) first „parcel of economic measures“ – cut of SB expenditures by cca 25 billion CZK (cca 5% of total expenditures) first „parcel of economic measures“ – cut of SB expenditures by cca 25 billion CZK (cca 5% of total expenditures) inner conflicts in the minority government – political destabilization inner conflicts in the minority government – political destabilization beginning monetary crisis in Southeast Asia beginning monetary crisis in Southeast Asia

Development of the crisis first attack on the CZK: 15th May 1997 first attack on the CZK: 15th May 1997 foreign short-term capital started to reflux foreign short-term capital started to reflux Czech National Bank tried to keep the CZK exchange rate Czech National Bank tried to keep the CZK exchange rate unequal „battle“ between the speculates and Czech National Bank unequal „battle“ between the speculates and Czech National Bank

BP development Current Account Financial Account Change of Reserves Start of the Monetary Crisis

Most important facts of the 2 crisis weeks DateImportant facts CZK depreciates by 5 %, first intervention of the central bank Pressure on the CZK continues, CNB raises the collateral loan interest rate to 50 % Another intervention of CNB, overnight IR rose to 38 % CZK under another attack, inter-bank IR rose to 500 % at one moment Sharp drop of CZK, CNB disallows foreigners obtaining short-term loans in CZK, firms and people convert deposits to foreign currencies, CNB loses 500 million USD Three ministers declare the aim to leave the government ER regime changed to “controlled floating”, former fluctuation zone cancelled CZK ER overshoots to 19,40/1 DEM CZK stabilized, the government introduces a program “the recovery package” of measures, personal changes in the government CZK returns to the border of former fluctuation zone, situation calms down

CZK exchange rate during the crisis Source: Centre for Economics and Politics (2000)

Main variables before and after the crisis Overnight interest rate10,79 %151,88 % Collateral rate14 %50 % Discount rate10,5 %13 % Foreign currency reserves of CNB11,518 billion USD10,025 billion USD Exchange rate CZK/DEM17,90319,180 Exchange rate CZK/USD31,00532,691 Exchange rate regime Fixed ER with 15% fluctuation zone Controlled floating without official fluctuation zone

Consequences of the crisis short-term consequences: personal changes in the minority government personal changes in the minority government governmental breakdown in autumn 1997 governmental breakdown in autumn 1997 sharp devaluation of CZK, change of ER regime sharp devaluation of CZK, change of ER regime mid-term consequences: premature parliamentary elections in 1998 premature parliamentary elections in 1998 changes in monetary policy changes in monetary policy economic recession in 1997 and 1998 economic recession in 1997 and 1998 constant unemployment growth since the end of 1997 constant unemployment growth since the end of 1997

The two different crisis explanations Oldřich Dědek – vice governor of CNB Oldřich Dědek – vice governor of CNB Václav Klaus – premier in 1997, current president of the Czech Rep. Václav Klaus – premier in 1997, current president of the Czech Rep. Oldřich Dědek explanationVáclav Klaus explanation Bad macro- and microeconomic situationGood situation of the national economy till 1996 No willingness to calm down the economy Parliamentary elections in 1996  minority government Expansionistic fiscal policy instead of the restriction No central bank cooperation No governmental cooperationStrong monetary restriction in June 1996 Constrained monetary restrictionInsisting on the fixed ER regime